For Smaller Companies, It's No Longer Accrual World

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In an effort to simplify tax accounting for many smaller businesses, the Internal Revenue Service has extended the use of cash-based accounting to certain companies with annual gross revenue of up to $10 million, replacing the previous $1 million ceiling. The change, applying to tax years ending on or after last December 31, reduces both the time and money being spent by an estimated 500,000 companies that have had to use accrual-based accounting in the past.

Accrual accounting requires taxes to be paid based on revenue incurred, while cash accounting requires tax payments only on collected revenue. So, says John Gillespie, co-president of CFOutsource LLC, a provider of financial and accounting services to small businesses, the benefits of allowing cash accounting will be especially significant for growing companies. He points out that a $3 million company with 60 days' worth of sales in receivables and a 35 percent tax rate would save more than $14,500 for the year. "This is a great savings, especially for someone who is self-financed, since those companies are almost prepaying taxes under the accrual method," he says.

The IRS also won't challenge the use of the cash method, or the failure to account for inventory in audits of earlier years, if taxpayers met the current safe harbors, according to Ken Silverberg, a tax specialist and partner in the Washington, D.C., law firm of Nixon Peabody LLP. Essentially, that makes the new rule retroactive. But the change won't apply to companies in industries that rely heavily on inventory for income--including retailers, wholesalers, manufacturers, mining, farming, and publishing--which have business models in which the accrual basis would be more appropriate.

What other tax simplification changes are expected? "The new commissioner [Charles O. Rossotti] understands the need," says Silverberg, but "the IRS hasn't given too many clues as to where it will try to simplify."